The bright side of the doom loop: banks’ sovereign exposure and default incentives

Luis Rojas and Dominik Thaler

No 2409, Working Papers from Banco de España

Abstract: The feedback loop between sovereign and financial sector insolvency has been identified as a key driver of the European debt crisis and has motivated an array of policy proposals. We revisit this “doom loop” focusing on governments’ incentives to default. To this end, we present a simple 3-period model with strategic sovereign default, where debt is held by domestic banks and foreign investors. The government maximizes domestic welfare, and thus the temptation to default increases with externally-held debt. Importantly, the costs of default arise endogenously from the damage that default causes to domestic banks’ balance sheets. Domestically-held debt thus serves as a commitment device for the government. We show that two prominent policy prescriptions – lower exposure of banks to domestic sovereign debt or a commitment not to bailout banks – can backfire, since default incentives depend not only on the quantity of debt, but also on who holds it. Conversely, allowing banks to buy additional sovereign debt in times of sovereign distress can avert the doom loop. In an extension we show that in the context of a monetary union (such as the euro area) similar unintended negative consequences may arise from the pooling of debt (such as European safe bonds (ESBies)). A central bank backstop (such as the ECB’s Transmission Protection Instrument) can successfully disable the loop if precisely calibrated.

Keywords: sovereign default; bailout; doom loop; self-fulfilling crises; transmission protection instrument; ESBies (search for similar items in EconPapers)
JEL-codes: E44 E6 F34 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2024-03
New Economics Papers: this item is included in nep-ban, nep-dge, nep-eec and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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https://www.bde.es/f/webbe/SES/Secciones/Publicaci ... 24/Files/dt2409e.pdf First version, March 2024 (application/pdf)

Related works:
Journal Article: The bright side of the doom loop: Banks’ sovereign exposure and default incentives (2024)
Working Paper: The bright side of the doom loop: banks’ sovereign exposure and default incentives (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:bde:wpaper:2409

DOI: 10.53479/36258

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